New Bank Bailout Could Cost $2 Trillion

By

Deborah Solomon,

David Enrich and

Jon Hilsenrath

Updated Jan. 29, 2009 12:01 a.m. ET

WASHINGTON -- Government officials seeking to revamp the U.S. financial bailout have discussed spending another $1 trillion to $2 trillion to help restore banks to health, according to people familiar with the matter.

President Barack Obama's new administration is wrestling with how to stem the continuing loss of confidence in the financial system, as it divides up the remaining $350 billion from the $700 billion Troubled Asset Relief Program launched last fall. The potential size of rescue efforts being discussed suggests the administration may need to ask Congress for more funds. Some of the remaining $350 billion of TARP funds has already been earmarked for other efforts, including aid to auto makers and to homeowners facing foreclosure.

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The administration, which could announce its plans within days, hasn't yet made a determination on the final shape of its new proposal, and the exact details could change. Among the issues officials are wrestling with: How to fix damaged financial institutions without ending up owning them.

The aim is to encourage banks to begin lending again and investors to put private capital back into financial institutions. The administration is expected to take a series of steps, including relieving banks of bad loans and distressed securities. The so-called "bad bank" that would buy these assets could be seeded with $100 billion to $200 billion from the TARP funds, with the rest of the money -- as much as $1 trillion to $2 trillion -- raised by selling government-backed debt or borrowing from the Federal Reserve.

The administration is also seeking more effective ways to pump money into banks, and is considering buying common shares in the banks. Government purchases so far have been of preferred shares, in an effort to both protect taxpayers and avoid diluting existing shareholders' stakes.

A Treasury spokeswoman said that "while lots of options are on the table, there are no final decisions" on what she described as a "comprehensive plan." She added: "The president has made it clear that he'll do whatever it takes to stabilize our financial system so that we can get credit flowing again to families and businesses."

Treasury Secretary Timothy Geithner said Wednesday that he wants to avoid nationalizing banks if possible. "We'd like to do our best to preserve that system," Mr. Geithner said. But given the weakened state of the banking industry, with bank share prices low and their capital needs high, economists say the government probably can't avoid owning at least some banks for a temporary period.

Stock-market investors have grown confident that the bailout plan will help the banks without wiping out their investments. Just over a week ago, investors dumped bank stocks, sending shares of some of the most vulnerable down to their lowest levels of the financial crisis. But as fears faded that the banks would be nationalized, financial stocks have rallied, and soared nearly 13% on Wednesday.

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In one of the steps under discussion, the government may shift how it injects money into banks, choosing to buy common shares. Bolstering banks' common equity is important because when a bank takes a loss, it has to subtract that amount from the value of its common equity. As losses mount, investors increasingly believe banks need to find ways to bolster this first line of defense on their balance sheets.

But buying common shares raises the likelihood that weaker banks will become largely government-owned. Bank share prices are so low that any sizable government investment in a bank would give the U.S. effective control of it.

The best approach is to have banks "under pretty heavy government control as briefly as possible -- basically long enough to take off the bad assets and recapitalize -- and sell the back to full private control as quickly as possible," said Adam Posen, deputy director of the Peterson Institute for International Economics in Washington.

Another way being considered for the government to inject money into banks is the purchase of convertible bonds -- in which the government would be paid interest now but have the option to get common equity later. That would give banks a chance to pay back the bonds as they recover, and avoid government control. Some critics of this approach say it would do little to solve the banks' current shortage of common equity.

The government is also likely to create a "bad bank" that would buy distressed assets from firms, helping them to avoid more damaging write-offs. The tricky question is figuring out how much the government should pay for these assets. That issue helped scuttle the Bush administration's plan to buy distressed assets. If the U.S. pays too high a price for the assets, it would essentially be shortchanging taxpayers. But if it pays too little, banks would have to take further losses.

Another option under discussion is insuring some of the assets against further losses. That is the route the U.S. has taken in its rescues of Citigroup Inc.C-0.71% and Bank of America Corp.BAC-1.38% Insuring the assets would limit the amount the banks could lose but wouldn't remove the securities and loans from their books. The government would cover any losses in the assets' value beyond agreed-upon levels.

Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia University, said that approach is preferable since it leaves the assets in private hands while giving investors confidence to put money into the institution.

"You have to eliminate prospective stockholders' concern that there's a bottomless hole at the banks," Mr. Calomiris said. "Getting them off the books solves that problem, but insuring against the downside would have a huge positive effect and might end up costing nothing."

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